Effects of Monetary Policy on Emerging Markets

The effects of monetary policy on the U.S. equities market are often scrutinized but can also be seen in the flow of money to other markets outside the U.S.

The effects of monetary policy on the U.S. equities market are often scrutinized but can also be seen in the flow of money to other markets outside the U.S. Investments in international and emerging market mutual funds can be influenced directly by shifting monetary policies, incurring increased and decreased capital flows in differing situations.

A study from the Asia School of Business analyzed 28,000 investment funds between January 2000 and December 2020. The authors paid particular attention the effects that both monetary policy and information shock have on international investment and emerging markets.

Monetary policy change occurs when the U.S. Federal Reserve takes action to increase or decrease interest rates as part of an attempt to either constrict or expand the economy. The study’s authors found that a pure monetary policy shock “captures a sudden shift in monetary policy that is orthogonal to changes in the economic outlook.” A tightening shock increases risk aversion and thereby reduces the flow of capital to all types of mutual funds. The effects are greatest for emerging market funds, since emerging markets are seen by investors as being riskier. Four weeks after a 10-basis-point (0.1%) shock, flows of investor dollars to emerging market stock and bond funds declined by around 0.3 and 0.6 percentage points.

An information shock “captures a change in the policy indicator that depends on changes in the Fed’s economic outlook (even if unexpected by the public).” A positive information shock, meaning the economy is performing better than expected, results in inflows to the U.S. and international equity markets. Capital flows to U.S. funds increased 0.2% versus 0.1% for global funds following a 0.1% positive information shock. Conversely, a negative information shock (weakening economy), sees a flight to bond and bond funds and reductions in riskier investments.

The study’s authors summarize that “an increase in interest rates driven by a pure monetary policy shock leads to persistent outflows from [emerging markets] and to a lesser extent global and U.S. mutual funds. On the other hand, when rates increase following a positive information shock investors reallocate capital out of U.S. bonds and into riskier mutual funds.”

Source: “The Effects of U.S. Monetary Policy on International Mutual Fund Investment,” by Gabriele Ciminelli, John Rogers and Webin Wu; Asia School of Business, November 2021.